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The Week Everything - And Nothing - Changed

What a week!!!

Seriously. As last week wrapped up I was pretty darn confident: Biden win stoked hopes of stimulus packages without tax cuts and ushered in an early bottom for gold. The price running from US$1,866 per oz. as high as US$1,956 on Friday seemed evidence enough, especially since the gain pushed gold up through a descending wedge.

And then came Monday and news of the vaccine. Pzifer and partner BioNTech announced that early results of its COVID vaccine yielded 90% efficacy, with little evidence so far of negative side effects. Hopes had been for 50 to 60% efficacy so 90% blew everyone’s socks off.

(Because I’m a scientist at heart, here’s the situation in a bit more detail. It’s a 44,000-person trial. Half got the vaccine; half got saline injections. Since the trial started 94 of the 44,000 have gotten COVID-19. Of the 94, only 9 had received the vaccine: 9/94 is the 90% efficacy rate. It will take a few more months for the numbers to get big enough for statistical significance but this is a very strong result at this stage – and the surge in cases around the world will ironically shorten the time to statistical results because the 44,000 in the trial are more likely to get exposed.

(It’s also interesting that the vaccine is the first vaccine ever based on messenger RNA. An mRNA fragment from the virus, specifically the fragment with the coding for the spike protein that the virus uses to latch onto human cells and initiate an infection, is delivered inside human cells. Once there the cellular machinery read the code and starts to produce the protein fragment, which is then used to train the immune system to detect and destroy the virus. Using mRNA is novel in the vaccine world – the idea has been around for years but an effective mRNA vaccine had not been developed, until now it seems.)

Markets went nuts. And so they should – a safe, effective, and widely dispensed vaccine is THE answer to COVID. Herd immunity is not a good option because it will take a long time to develop, during which time economic pain will persist (and more people will die). A vaccine would not only ease lockdowns but actually re-open the economy – travel, parties, sports, recreation activities, casinos, busy restaurants and bars, all the things that have been sidelined since March. None of that can happen until there’s a vaccine and, without that huge part of the economy, unemployment will stay high and expandable cash low.

Of course, early results from one vaccine do not heal a broken economy overnight. And so markets gave back most of their gains before close on Monday. They have since worked their way back up in a more reasonable manner.

What’s the outlook from here? Upwards for equities is my guess, because
  • All the money that’s been sitting on the sidelines through COVID looking for a reason to get back in just got one – vaccine
  • There will still be a stimulus package, is my guess. It will be smaller than was envisioned a few months ago because a Republican senate (I’m assuming the Georgia special races in January leave Republicans in control of the Senate) will demand smaller and vaccine weakens the reasons for a big package. Nonetheless, the Democrats will I think follow through on promises to support families, businesses, etc hurt by COVID – and the damage is very real, vaccine or no vaccine, so the support is arguably still justified.
  • A vaccine (real reason for economic optimism) plus stimulus (fiscal reason for optimism) should combine to support stocks
Of course, the news hammered gold and silver.

What’s the outlook there? I think it’s impacted but largely unchanged.

Investors have not been buying gold only because of COVID 19. I think the most important forces driving gold are negative real interest rates and big pools of low-risk money needing to hedge their stock exposure. And those remain in place.

Real interest rates peaked in late 2018 and then started to drop when the Fed acknowledged that pretending that tightening was not working (at least, not working for the stock market).
COVID undoubtedly poured fuel on the fire by slamming interest rates to zero, shuttering the global economy, and sparking massive monetary and fiscal response – but the flame actually lit in late 2018 when real rates started falling.

So what does a vaccine mean for real rates? It brings real recovery closer but it doesn’t change the monetary regime in the near term. Central bankers have been very clear they will not tighten one bit until thing normalize, which in the US means unemployment of 5% or less and official inflation above 2%.

It will take a lot of real recovery to get unemployment back down to a range like that. As for inflation – we have to take that one in stages.

Step one: massive fiscal stimulus boosts inflation expectations. Those rising inflation expectations were the primary reason gold went on such a run May through August.

Step two: Justice Ginsburg dies and the follow stimulus package, a huge set of supports that had almost achieved bipartisan support, dies with her. Partisan fighting and a looming election mean stimulus is delayed until November or January, depending on the results. Inflation expectations ease; gold eases alongside.

Step three: election puts Biden in the White House while vaccine news stokes hope for real recovery sooner. Combination of some additional stimulus plus a return to normal operations for the global economy over the next year stoke inflation expectations again.

And there’s the thing: gold is not simply a safe haven when everything else crumbles. If a vaccine works and is safe and can be distributed, we should get back to economic growth. That should create inflation. Until the Fed starts raising interest rates, any inflation will only work to lower real rates. So yes: growth-based inflation could well lead to lower real rates, given that central bankers will be very reticent to tighten in any way, shape, or form until strong growth is abundantly clear.

And then there’s the timeline. The very best case scenario here is that Pfizer’s vaccine become available first in late Q1. That’s still months away. Case counts are rising very rapidly in Europe and North America, enough that Christmas is threatened (talk about kicking retailers when they’re down) and health care may get overrun once again. So odds of fear and volatility in the near term are high.

Stepping back, central banks are also hamstrung in their ability to raise rates because government and corporate debt burdens are SO high.
This isn’t a COVID chart. Of course COVID made its mark, but negative-yielding bonds have been on the rise since the Great Financial Crisis. Today more than 80% of global bonds trade at less than 2% nominal yield, which means they offer return-free risk when you take inflation into account.
This bring me back to the start of my outlook-for-gold comment: the other key force supporting the yellow metal is that safe money has to hedge its stock market exposure. Safe money used to own bonds. It was the obvious game – low risk and 5 to 6% annualized returns. But that game does not exist anymore. Bonds don’t pay.

And so the huge pools of low-risk capital that used to own bonds now have to own stocks. That’s ok, at least in that they have done pretty darn well in equities since the GFC, but low-risk money managers have to hedge the risks inherent in the stock market. It doesn’t even matter how bullish they are on the markets – they have to hedge.

But there aren’t many options. There’s diversification among equities. And there’s owning some US Treasuries as a last resort. And there’s gold.

That rationale is why gold-backed ETFs have seen SO much buying since the GCF. Buying pressure eased 2013 through 2015 because real growth in a supportive monetary environment created real reason for stocks to appreciate…but as soon as that show ended (with the Fed raising rates in early 2016) low-risk money needed to hedge its stock market exposure and it did so by buying gold.
Will this pattern continue? I think it will. The Fed is not going to raise interest rates any time soon. Even if we get a vaccine in late Q1 it will take months to distribute it and much longer for the economy to heal the slew of injuries that COVID wrought. And even when real growth starts to generate real inflation, the Fed will move carefully to raise rates knowing the ridiculous debts that companies and governments have to service.

Was the prognosis for gold better before the vaccine news? Yes. But a vaccine isn’t a quick fix, just like an election was never going to solve the divisions and discord in the United States. The damage is severe and still rising, the vaccine still faces some big hurdles, and once a vaccine is ready it will take significant time for injuries to heal.

Through all of that, interest rates will stay at zero, which means real rates will stay negative. Low risk money will have to own stocks, which means they will have to hedge. And gold will benefit from both forces.

To finish, let me convey a parallel that Canaccord analyst Martin Roberge laid out in a note. He said this last week reminds him of late 2009, early 2010.

“ Back then, the economy was coming out of the GFC, and gold was ripping on the back of a sidelined Fed and QE1. In early February, just when it looked like gold had bottomed out, the bullion plunged $50/oz or ~4% in one session as the Greek debt crisis was unraveling, causing a flight to safety in the US$. Gold troughed the following day with the 3-month ROC deep in negative territory. The bullion rose 34% from February 5 to December 31, 2010. Fast forward 10 years and gold rips in 2020 on the back of a sidelined Fed and QE infinity. After a 3-month correction, it looks like gold is ready to go, but boom, the bullion dives $100/oz Monday. But like in 2010, the bullion is oversold. The tailwinds that drove the bullion above $2,000 this year will likely remain over the next several months. Thus, the “pain” trade is to swing (buy) at this week’s fat pitch.”
-- Canaccord Genuity’s Martin Roberge: Portfolio Strategy Incubator, 11 Nov 2020

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